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Fresh selling sweeps through global markets

World equity markets continued to tumble as fears over the growing crisis in the US subprime mortgage market triggered fresh selling.

After Wall Street slumped overnight, Asian and European bourses were hit hard as investors headed for the safer investment havens such as government bonds. Credit markets also continued to weaken. In Asia, the sell-off was broad and deep on investors worries that the supreme mortgage problems could hit the US housing market and the broader US economy - a big export market for many of the region’s companies. The Tokyo stock market plunged 2.9%, Singapore by 3.3%, Mumbai dropped 3.3%, Hong Kong by 2.5% and Shanghai by 1.9%. In Europe, heavy falls were also seen as rattled investors offloaded stocks. By mid-morning in London, the FTSE Eurofirst 300 index was down 1.83% while the FTSE 100 index in the UK had slumped 1.58%. Elsewhere, the Xetra Dax index lost 1.58% in Germany, the CAC-40 index by 1.84% in Paris and the Swiss market fell by 2%. Futures market trading indicated expectations that on Wall Street, the Dow Jones Industrial Average would open broadly flat to lower on Wednesday.

The yen held steady, consolidating sharp overnight gains as US equities tumbled. Analysts said the consequent rise in risk aversion benefited the Japanese currency on Tuesday as investors unwound carry trades, in which the purchase of riskier high yielding (Y) assets is funded by selling the yen. However, the foreign exchange markets stabilized on Wednesday as investors awaited fresh direction from the US equity market.

The yen was steady at Y116.05 against the dollar, rose 0.1% to Y153.12 against the euro and climbed 0.2% to Y224.10 Meanwhile, the high-yielding Australian and New Zealand dollars, which were particularly hard hit on Tuesday, rallied modestly, rising 0.5% to Y90.96 and gaining 0.3% to Y79.90 respectively. On government bond markets, German bunds strengthened. The benchmark 10-year yield was down 0.7 basis points to 3.88%, having fallen to a new low for the year of 3.87%. Credit markets were generally weaker. The iTraxx Crossover index, a key benchmark of sentiment for riskier credit in Europe, widened 10bp to 238bp above government bonds. The index has widened almost 40bp in the past two days.

Julian Jessop, chief international economist at Capital Economics, said although the full extent of the problem was not clear, at the very least, the sub-prime crisis can be expected to worsen the downturn in the US housing market. „We think it is right to be concerned, particularly about the knock-on effect on US consumer spending. Moreover, the US sub-prime mortgage market is yet another example of the financial excesses and extraordinarily high degree of risk appetite that have supported a wide range of asset prices in recent years,” he said.

David Rosenberg, North American economist at Merrill Lynch, said the direct macroeconomic effects of sub-prime stress were likely to be fairly small. But he was concerned about the knock-on effects from the pullback that the US was most certainly going to see in mortgage credit availability. „Even if the pullback is only aimed at the sub-prime market, there could well be potentially significant further drags on home prices, construction activity and of course consumer spending growth via the reduced wealth effect,” he said. „It is not inconceivable (given what is happening now to mortgage originations) that we end up with something closer to a 10% decline in home prices this year. This would shave a further 0.5 percentage points off GDP growth via the wealth effect, which means GDP growth this year comes in around 1¾%, closer to 1½% by the end of the year; and the unemployment rate goes back above 5% by the end of 2007 from 4.5% right now. “ „That’s not a classical recession, but it’s what we call a growth recession, and an old rule of thumb says that anything lower than 2% GDP growth generally spells a weak credit environment. ” (